Central banks fail to impress

Three central banks acted within a short time of each other to provide yet more monetary stimulus. However, the European Central Bank’s (ECB) 25 bps cut in its refi rate and deposit rate, China’s central bank, PBoC’s cut in interest rates and an additional GBP 50 billion of asset purchases by the Bank of England have failed to stimulate markets. This is a worrying development for policy makers especially as the drug of monetary stimulus has been a major factor spurring equity markets and risk assets since the global financial crisis began in 2008.

The lack of positive momentum emanating from the policy easing by central banks yesterday reflects the reality that the efficacy of further easing has now become very limited. Will a quarter percent rate cut from the ECB or yet another round of asset purchases from the BoE really make a difference at a time when core bond yields are already at extremely low levels and the demand for credit globally is very weak? Moreover, are policy makers really addressing the underlying problems in the Eurozone or elsewhere? I think the answers are obvious.

The same argument applies to the Fed if it was to embark on a third round of quantitative easing. Admittedly more Fed QE could weaken the USD and boost equities but would it really have a lasting impact? In any case I don’t think the Fed is on the verge of more QE following the recent extension of ‘Operation Twist’ which itself will do little more than have a psychological impact on markets. Today’s release of the June jobs report could give some further impetus to QE expectations if it comes in weak but I doubt this will occur.

One casualty of the cut in ECB rates was the EUR which dropped sharply, having not only given up its post EU Summit gains over recent days but extending its losses even further. This is perhaps an odd reaction considering that a rate cut was widely expected. ECB President Draghi’s warnings about the path ahead will have played negatively on the currency as well expectations of more stronger easing in the months ahead perhaps involving ECB QE.

I still stick to the view that European policy makers have at least put a short term floor under the EUR in the wake of the decisions at the EU Summit suggesting that further downside will be limited, with the 2012 low around 1.2288 likely to act as a short term floor for EUR/USD. Nonetheless, with many details of the plans announced in the Summit yet to be ironed out and implementation risks running very high a degree of market caution should be expected.

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Plenty of event risk

In the wake of the EU Summit at the end of last week sentiment has stabilised, with risk indicators such as the VIX ‘fear gauge’ reflecting a firmer tone to risk appetite. Although a few stumbling blocks have arisen such as the objections by both Finland and Holland to bond purchases by the ESM bailout fund they may not be sufficient to derail the project. The euphoria is likely to fade in the days ahead but the US Independence day holiday tomorrow may keep trading somewhat subdued.

There are plenty of events this week including central bank decisions by the RBA (Australia), Riksbank (Sweden), ECB (Eurozone) and BoE (UK), to provoke some excitement. A likely rate cut from the ECB and an extension of asset purchases by the BoE will give markets plenty to chew on. Finally, at the end of the week the US June jobs report will also be closely watched. We forecast a 100k increase in payrolls but will look for clues from tomorrow’s ADP jobs report.

The disappointing US June ISM manufacturing survey released yesterday highlighted that growth risks will remain a key weight on the market dampening any improvement in risk appetite over coming weeks. Moreover, weaker growth in Europe will make it more difficult to achieve budget targets, while adding to pressure to ease bailout terms. Undoubtedly the European summit was a step in the right direction but with plenty of details still needing to be thrashed out and growth concerns intensifying it would be highly optimistic to expect a fully fledged ‘risk on’ to ensue.

Notably the EUR has given back some of its gains after failing to break above 1.2700 against the USD. Further downside is likely but the EU Summit outcome has meant that the risk of a sharp drop lower has receded. Although there is likely to have been some short covering following the summit outcome EUR short positions remain significant, a factor that may also limit downside in the currency. EUR/USD will find some short term support around 1.2553 but will likely edge down to around 1.2500 over coming sessions.

Progress at last in Europe

As last week progressed markets had been increasingly poised for disappointment at the EU Summit at the end of the week. Given such low expectations it was probably not so difficult to exceed them. In the event there was progress towards breaking the vicious cycle between banks and sovereigns. The immediate reaction to the announcements from the EU President was clearly positive, with risk assets rallying sharply. EUR/USD had rallied by over 2 big figures from a low just above 1.24 as a massive short squeeze helped propel it higher.

With their backs against the wall EU leaders finally agreed upon short term stabilisation measures as well as long term measures towards closer European integration. Under pressure from other leaders including French President Hollande, German leader Merkel obviously softened her stance to agree on some of these measures. The deal goes to show that leaders in Europe can act when needed or at least when desperate which is how they were after 13 hours of talks and the reality that bond yields in Spain and Portugal were at unsustainable levels.

Short term measures in particular utilising the EFSF / ESM bailout fund to recapitalize banks directly and the creation of a European banking supervisory body was a shot in the arm for Italian and Spanish bonds and the EUR. The dropping of the condition that EU governments be given preferred creditor status for loans to Spanish banks bodes well for peripheral Eurozone sovereign debt markets as it means that private investors will not be put at the back of the que in any debt restructuring.

While the measures mark an important step in the direction of providing clear resolutions to the Eurozone crisis there is a very long way to go. Admitedly the use of the bailout funds is positive but at some point markets will ponder the fact that while they could handle a bailout of Spain the funds are clearly insufficient to cope with a bailout of Italy should it be needed. If the steps announced at the EU summit lead to a sustained drop in peripheral country bond yields then the prospects of more bailouts will be limited but this is by no means guaranteed.

Whether the risk rally is sustained into next week depends in part on whether the European Central Bank responds with actions of its own by cutting interest rates or by indicating the use of other measures such as restarting its securities markets purchases program. The risk remains that the rally will likely fade as skepticism sets in again once again and more details are sought.

More bad news in Europe, INR not impressed by new measures

Nervousness or simply just impatience is growing ahead of the EU Summit beginning on Thursday. The formal application by Spain for a banking bailout of up to EUR 100 billion has started the process while Greece is looking to renegotiate the terms of its bailout following the formation of a new government in the country.

European equities are not reacting well, however, with sharp declines registered yesterday following by drops in US stocks. Risk assets have come under pressure as noted by the sharp 12.5% jump in the VIX index overnight while the USD index continued to strengthen.

Interestingly despite the rise in risk aversion, many high beta currencies are holding up reasonably well. Indeed, those with the biggest sensitivities to risk such as ZAR, MXN, PLN and EUR have failed to drop while implied currency volatility has been falling over recent weeks. This may reflect the beginning of summer trading conditions rather than resilience in currency markets but nonetheless, it suggests a dose of FX calm ahead of the EU summit.

EUR/USD came under pressure hitting a low around 1.2471 failed to extend losses. The bad news intensified and included the formal Spanish bank aid request, Moody’s downgrade of 28 Spanish banks’ ratings, Fitch’s decision to cut Cyprus’ ratings to junk status, lack of concessions from German Chancellor Merkel who maintained her strong stance against common Eurobonds and inflexibility about the use of rescue funds. As a result it looks increasingly unlikely that a concrete plan will emerge from this week’s EU summit. EUR/USD will find technical support around 1.2442 and resistance around 1.2584.

One currency that has failed to perk up is the Indian rupee. New measures announced yesterday to shore up the INR including a $5 billion increase in the foreign investment cap in government bonds and an increase in the limit for domestic firms to borrow from overseas of up to $40 billion, failed to have more than a fleeting impact on the currency.

What were missing were measures to increase exports and cut excise duties. The measures left markets who had expected much more, with a taste of disappointment. While the measures are a decent starting point clearly much more will need to be done to appease markets and reverse the gloom among INR bears.

Caution ahead of EU Summit

Risk appetite has continued to firm over the last few weeks although notably risk is still elevated compared to the the levels seen in May, suggesting that there is some way to go before risk appetite normalises. Improving risk appetite perhaps reflects rising expectations of a credible set of solutions to the Eurozone crisis but various summits and official meetings including the G20 meeting have failed to deliver anything of this nature.

Attention will turn to the EU Summit on 28-29 June where various issues ranging from debt mutualisation to fiscal and banking union as well as a potential renegotiation of Greece’s bailout terms, will be discussed. Markets are likely to remain relatively range bound ahead of the Summit.

There are also plenty of data releases to contend with over coming days including new home sales, consumer confidence and durable goods orders in the US as well as flash CPI inflation estimates, economic confidence gauges and Italian debt auctions in the Eurozone. Japan will release inflation data too and industrial production data.

On balance US data will continue to outperform although consumer confidence is likely to slip in June. In Europe, confidence indices will reveal some further deterioration in June, while in Japan weak industrial production and a drop in monthly inflation will maintain the pressure on policymakers to act in the country.

The USD will continue to find support from the fact that the Fed did not implement more quantitative easing but firmer risk appetite will cap the ability of the USD to strengthen much from current levels. It is notable that the USD long positions dropped sharply according to IMM data ahead of the Fed meeting but it is likely that Fed QE inaction will result in some rebuilding of USD longs.

In any case, given the uncertainty ahead of the EU Summit it is unlikely that the EUR will break out of its current ranges. Notably there was a major bout of EUR short covering last week, with EUR/USD shorts dropping sharply according to the IMM data. Hopes ahead of the EU Summit may encourage more short covering but as usual scope for disagreement and disappointment on many fronts, suggests that investors should not become overly bullish. EUR/USD will find some initial resistance around 1.2583 to any upside.

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